Twilight Zone Economics

It is obvious to me that the world of economics has now fully entered the Twilight Zone. As evidence, last week, European Central Bank Head Mario Draghi pledged to quote, “Do whatever it takes preserve the Euro. And believe me, it will be enough.” In this upside down world of phony Keynesian Economics, doing “whatever it takes to preserve the Euro” apparently now means promising to dilute the purchasing power of the currency into oblivion.

The ECB plans to use their hoard of freshly-minted counterfeit money to purchase the insolvent debt of bankrupt nations. Incredibly, the ECB’s dedication to create unlimited inflation actually served to send bond yields much lower. The Italian 10 year note plunged 77 bps and the Spanish 10 year note dropped by 88 bps just days following the announcement. What’s more, the Euro unbelievably rallied to a three-week high.

Sane individuals realize that the ebullient reaction from Southern European currency and bond markets can only be temporary at best. True economic principles are as immutable as those that exist in mathematics and science. One of those principles is that a central bank cannot pursue a massive inflationary policy without sending its currency and bond market crashing in the long term.

“To the extent that the size of the sovereign premia (borrowing costs) hampers the functioning of the monetary policy transmission channel, they come within our mandate,” Draghi also said at an investment conference in London. By saying that, the ECB president has unwittingly committed to endless money printing. Which would if executed to its fullest extent, send Europe into an inflationary death spiral. That is, a situation where there is no longer a private market for a country’s debt at current yields and the central bank becomes the predominant buyer. Therefore, they must continuously and massively print money in an effort to stop yields from rising. Otherwise, debt service payments would bankrupt the nation and cause a severe depression. However, those very same hyperinflationary actions of the central bank force borrowing costs to surge despite those efforts to artificially manipulate rates lower. Thus, the economic destruction occurs regardless, albeit with greatly increased intensity.

Not to be outdone by their European counterpart, the Wall Street Journal reported last week that the Fed would soon act to spur America’s faltering economic growth. Friday’s anemic 1.5% GDP number only served to underscore that notion. In fact, NY Senator Chuck Schumer scolded Mr. Bernanke recently saying, “Get to work Mr. Chairman.” Apparently, Mr. Schumer doesn’t think four years of zero percent interest rates, a promise to keep them at zero until at least the end of 2014 and printing $2 trillion, doesn’t amount to doing much of anything and it is time for Mr. Bernanke to do something really extraordinary.

Joining Mr. Schumer was former Vice-Chair of the Fed Alan Blinder, who wrote in the Journal that the central bank should not only consider stop paying interest on excess reserves but should also charge banks interest on reserves that they don’t loan out. That action would undoubtedly lead to an explosion of money supply growth and rising prices.

It is now becoming blatantly apparent that the central banks of the developed world are becoming desperate in their pursuit to fight deflation. And despite what the perennial deflationist contend, a central bank can always create inflation when they so choose. All they need is a firm commitment to destroy the value of the currency and have a government that is compliant towards that goal. That situation is quickly coming into fruition in Japan, Europe and the United States.

In preparing your portfolio to prosper during rapidly rising inflation you must also try to get the timing correct. The time to gear away from deflation is approaching quickly. Having some exposure to precious metals and writing covered calls against the position is currently a good strategy. Then, you must be ready to deploy a good proportion of your assets in the precious metal, energy and agricultural sectors once the Fed and the ECB follow through on their threats to take even greater steps to destroy their currencies. From all available evidence, that day is now fast approaching.